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Stability and Growth of the Euro

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“Consider the advantages and disadvantages of the Stability and Growth Pact in its present form within the euro area and critically discuss the extent to which the pact remains intact.”

Abstract

The main purpose of this essay is to examine and critically assess the above quoted question in relation to the advantages and disadvantages of the Stability and Growth Pact in its present form within the euro area. However, from the year 2002 onwards, the Euro has become the common currency of the twelve member’s countries of the European Union (EU).

In order to ensure the functioning of this European Monetary Union (EMU), the member countries have agreed on the Stability and Growth Pact (SGP), which guarantee’s members of the economy before the introduction of the currency and internal Stability of the Euro – Zone afterwards.

During the 1990’s the economic significance has been discussed, especially because the countries violated the use of Stability and Growth Pact (SGP) political power within the EU System.

In order to critically discuss the underlying issues on the advantages and disadvantages of the Stability and Growth Pact in its present form within the euro area, I will be looking at various references such as journals, various articles and other sources in order to support my research.


Introduction

In 1958 the establishment of the currency system within the European Communities (EC), the Head of States and the Governments decided to make the economic and the monetary union the official goal of the European Integrations.

Although, in the 1970 Werner plan was to propose to coordinate the economy policy to the six member countries to create a system of fixed common currency. Unfortunately, this attempt failed due to the global system of a fixed exchange rate, which came into force from 1945 until 1973 (Bretton-Woods-System).

The Stability and Growth Pact (SGP) Framework

During the mid 1990s, the public fears raised in Germany this was that the EDP would not be sufficient to discipline economic policies effectively after the start of the European Monetary Union (EMU). In 1995 Germany’s former finance minister - Theo Waigel, responded to these fears by proposing a Stability Pact for the European Monetary Union (EMU). This was than later adapted in Amsterdam as the ‘Stability and Growth Pact’ by the European Council Brunila, 2001.

Creel, 2002 identifies the SGP modifies the EDP in several ways.

Firstly, it commits the member states to the new and medium term objective of achieving budgets ‘close to balance or in surplus’. This is a more specific goal than avoiding excessive shortfall and a more ambitious one than the reference value for shortfall under the EDP.

Secondly, it also created an early warning system strengthening the surveillance of the public finances of the member states. Under the SGP, EMU economies submit annual programmes are known as ‘Stability Programmes’. Euro group participants explaining there intended economic policies and particularly, what they plan to do to reach and maintain the medium–term objective. Stability Programmes include annual economic targets as well as an explanation of the main economic assumptions underlying them.

Thirdly, the SGP gives more importance to the concept of exceptional and temporary breaches of the 3% insufficiency limit. However, in doing so, it completely defines an excessive insufficiency based on the 3% insufficiency limit. The SGP clarifies the rules for the financial penalties and speeds up this process by setting specific deadlines for the individual steps.

Fourthly, the SGP provides a political guidance to the parties involved in the EDP, calling them to implement the rules of the EDP effectively and in good time. It commits the Commission, in particularly to use its right of initiative under the EDP in a manner which facilitates the timely and effective functioning of the SGP’. This however, puts severe limits on the Commission’s right to exercise judgement on each individual case and situation, shifting the right to the Council.

Creel 2002 states that in October 1998, the rules of the SGP have been steadily improved. ECOFIN endorsed a Monetary Committee Opinion, the ‘code of conduct’ that specifies criteria to be observed in the assessment of a country’s medium term budgetary position, data standards and requirements for the programmes.

The European Council of Amsterdam and two additional Council Regulations formally made SGP decisions in 1997. (Stability and Growth Pact, 1997) identifies the strengths of the surveillance of budgetary positions, co–ordination of economic policies and on speeding up and clarifying the implementation of the excessive insufficient procedure.

The collective surveillance mechanism of the SGP is based on three elements: the medium term early warning system, the short-term observation of national budget programmes, and the excessive budget procedure.

The early warning system basically consists of annual stability programmes submitted by EMU member countries and union programmes by the other EU countries. The official programmes are addressed to the Council of EU finance ministers (ECOFIN), the EU Economic and Financial Committee (EFC), with two representatives from each member state, the European Commission and the ECB.

Essay Marking

Artis and Buti, 2000 identifies the main contents of the stability programmes are:

The Council then decides within two months whether the medium–term budget aims contain an adequate margin of security to prevent an excessive shortfall of 3% of GDP, whether the plan’s assumptions are realistic and whether the planned measures provide for a stable budgetary development. If not then the country has to revise its planning and report once more.

Short–term surveillance is provided in the form of semi–annual reports of current national budget data on 1 March and on 1 September each year. The EU–Commission and the EFC examine separately from one another whether there is an excessive budget deficit.

As a result this is normally the case if at least one of two criteria from the SGP is not met the budget shortfall is higher than 3% of GDP, or the debt threshold is higher than 60% of GDP or is not approaching this point of reference with adequate speed.

If an excessive shortage has been identified or is expected, the procedure for an excessive shortage according to article 104 TEC and the SGP is initiated. As procedure the Commission and the EFC first present their considerations to ECOFIN which then decides with a qualified majority of votes whether there is in fact an excessive shortage or not.

Critically this decision is whether or not there are any exceptional circumstances justifying a higher shortfall, if certain exceptions are natural disasters, a solely temporary character of the shortfall, or a recession.

A recession is operationalised by a reduction of GDP within a year. A reduction of less then 0.75% is defined as not exceptional, a reduction of 2% is generally accepted. But however, the Council decides on indeed percentages within these two reference values. The position of the causing problems for the country as well as the unexpectedness and the cumulative effect of the shocks are taken into consideration.

Article 104(7–11) TEC come into force if the Council concludes that there is in fact an excessive shortfall. Firstly, the Council gives some confidential advice to the country, in order to reduce shortfall this may be made public.

Therefore, if the country still does not comply with these directions, the Council may impose allows enforcing the implementation of the combined measures. These include the requirement needs to give additional information when releasing government bonds, revisions in the lending policies of the European Investment Bank, the obligation to give a no interest–bearing deposit bearing no interest to the Union, and the burden of fines.

The period between the submission of the budgetary data and the decision to impose potential sanctions is only ten months. In October 1998, the Code of Conduct, as agreed by EFC and endorsed by ECOFIN, subsequently it was revised in June 2001 which then was clarified the content and format of the Stability and Convergence Programmes as part of the surveillance process.

The main targets was strengthening and clarifying the implementation of the

SGP. These included that

Despite the huge European Fiscal Framework and the whole process together with EU–Commission, ECOFIN and national stability programmes of all EU member states, the national economic authority of each member state have the independence over economic policy. They set specific objectives of policy and make policy decisions about the overall view of economic tax- and spending policies.

Compared with the original EDP, the SGP has achieved two advances: Firstly, it has shifted the nature of the fiscal framework significantly towards a rule– based concept restraining annual deficits and away from a framework based on informed judgement. Secondly, it has weakened the position of the European Commission in the process, to the benefit of ECOFIN Calmfors, 2005.

Maastricht Treaty gave the Commission considerable discretion in initiating the EDP and advancing it. The SGP made the process more automatic and reduced the Commission’s role and raised the importance of ECOFIN judgements.

The connection between the EDP and SGP has completely changed the role of the numerical reference values for the annual debts from an assessment process in the pre Maastricht period into a ‘binding constraint’.

Therefore any breaching of the SGP requires swift corrective actions by the Member State concerned and a timely commencement of the Excessive Deficit Procedure Solbes, 2002. Two factors have advanced this development.

The first is the lack of credibility in the process. This was already a problem in the EDP. It has now however become more courteous due to the increase in the ministers power against the EU–Commission and for this reason it will tend to do more economically negligent.

The European public and the media have paid increasing attention to it and criticised on the interpretation of the EMU economic framework. Particularly the ’Stability and Growth Pact’. However, EU–Commission’s assures that the economic framework is applied equally to all member countries, and it confirms that the Commission’s general role as the institution watching over the proper implementation of EU law.

As a result the nature of the fiscal framework has been transformed from a procedural ruled by oversight and informed judgement, as foreseen by the Maastricht Treaty, into a severe numerical rule for the annual budget shortfall.

Advantages of the Stability and Growth Pact in its Present form within the Euro Area.

Transaction costs will be eliminated - For instance, UK firms currently spend about £1.5 billion a year buying and selling foreign currencies to do business in the EU. This is increasingly profitability of EU firms.

Price transparency - EU firms and households often find it difficult to accurately compare the prices of goods, services and resources across the EU because of the distorting effects of exchange rate differences this discourages trade.

According to economic theory, prices should act as a procedure to allocate resources in the best possible way as to improve economic efficiency. There is a far greater chance of this happening across an area where E.M.U exists.

Uncertainty caused by Exchange rate fluctuations eliminated - Many firms become wary when investing in other countries because due to the regular fluctuation of currencies within the EU. Investment would rise in the EMU area as the currency is universal within the area; therefore the anxiety that was previously apparent is there no more.

Single currency in single market makes sense – Trade should operate more effectively and efficiently with the Euro. Single currency in a single market seems to be the way forward.

Rivalry - If we look out in the world today we can see strong currencies such as the Japanese Yen and The American $. America and Japan both have strong economies and have high population. A newly found monetary union and a new currency in Europe could be a rival. EMU can be self-supporting and so they could survive without trading with anyone outside the EMU area. The situation that EMU is in is good, as it seems that it can survive on its own, with or without the help of Japan and U.S.A.

Prevent war - The EMU is, and will be a political project. It's founding is a step towards European integration, to prevent war in the union. It's a well-known fact that countries that trade effectively together don't wage war on each other and if EMU means more happy trade, then this means, peace throughout Europe and beyond.

Increased Trade and reduced costs to firms – Supporters of the move argue that it brings considerable economic trade through the wiping out of exchange rate fluctuations, but as well as this it helps to lower costs to industry because companies will not have to buy foreign exchange for use within the EU. EU represents the completion of the Single European Market

Inflation - From the mid-1980s onwards, there were a number of economists and politicians who argued that, for the UK at least, EMU provided the best way forward to achieve low inflation rates throughout the EU. During the first half of the 1980s high inflation countries, such as France and Italy were forced to adopt policies, which reduced their inflation rates.

Therefore, if they had not done this, the franc and the lira would have had to be periodically devalued, opposing to the fixed exchange rate advantages of the system. Effectively, the German central bank, the Bundesbank, set inflation targets and therefore monetary targets for the rest of the EU.

At the time, there was much discussion of why Germany had a better inflation record than many other European countries. This was due to the German central bank being independent of the German Government.

In countries such as the UK and France, governments controlled central banks. If the UK government decided to loosen monetary policy, for example, by reducing interest rates, it had the power to order the Bank of England to carry out this policy on its behalf.

The Bundesbank, in contrast, was independent of government. By law it has a duty to maintain stable prices. It can resist pressures from the German government to pursue reflection policies if it believes that these will increase inflation within the economy.

Events of the early 1990s have shaken the naive faith that linkage to the independent ESBC, the central bank of Europe would solve all inflationary problems.

This is because German inflation rates in the early 1990s rose to over 4% as Germany struggled with the consequences of integration. In 1993, inflation was nearly three times as high in Germany as in the UK and twice as high as that in France. Some countries, such as France, have made their central banks independent on the Germany model and therefore arguably don't need to the EMU link to Germany to maintained low inflation.

The UK has gone a little way towards giving more power to the central bank by publishing reports neither of monthly meetings between the Chancellor of the Exchequer and the Govern nor of the Bank of England. This forces the Government to justify its monetary policy publicly and makes it harder for it to use interest rates for short-term political ends.

Disadvantages of the Stability and Growth Pact in its Present form within the Euro Area.

The instability of the system - Throughout the 1980s the UK refused to join the ERM (Exchange rate mechanism). It argued that it would be impossible to maintain exchange rate stability within the ERM, especially in the early 1980s when the pound was a strong currency and when the UK inflation rate was consistently above that of Germany.

In the year 1990 when the UK joined the ERM there had been three years of relative currency stability in Europe and it looked as though the system had become relatively strong. The events of Sept. 1992, when the UK and Italy were forced to leave the system, showed that the system was much less strong than had been thought.

Over estimation of Trade benefits - Some economists argue that the trade and cost advantages of EMU have been grossly over estimated. There is little to be gained from moving from the present system, which has, some stability built into it, to the inflexibilities, which EMU would bring.

Loss of Sovereignty - On the political side, it is argued that an independent central bank is unfair. Governments must be able to control the actions of the central banks because the people have democratically elected Governments, whereas a non-elected body would control an independent central bank.

Moreover, there would be a considerable loss of sovereignty. Power would be transferred from London to Brussels. This would be highly undesirable because national governments would lose the ability to control policy. It would be one more step down the road towards a Europe where Brussels was akin to Westminster and Westminster akin to a local authority.

Deflationary tendencies - The most important economic argument relates to the deflationary tendencies within the system. In the 1980s and 90's France succeeded in reducing her inflation rates to German levels, but at the cost of higher unemployment, For the UK, it can be argued, that membership of the ERM between 1990 and 1992 prolonged unnecessarily the recessional period.

This is because the adjustment mechanism acts rather like that of the gold standard. Higher inflation in one ERM country means that it is likely to generate current account deficits and put downward pressure on its currency. To reduce the deficit and reduce inflation, the country has to deflate its economy. In the UK, it could be argued that the battle to bring down inflation had been won by the time the UK joined the ERM in 1990.

However, the UK joined at too high an exchange rate. It was too high because the UK was still running a large current account deficit at an exchange rate of around 3 Dm to the pound. The UK government then spent the next two years defending the value of the pound in the ERM with interest rates, which were too high to allow the economy to recover. Many forecasts predicted that, had the UK not left the ERM in Sept 1992, inflation in the UK in 1993 would have been negative (i.e. prices would have fallen).

Another problem that the early 1990s highlighted was that the needs of one part of Europe could have a negative impact on the rest of Europe. In the early 1990s, the Germans struggled with the economic consequences of German reunification. There was a large increase in spending in Germany with a consequent rise in inflation.

The Bundesbank responded by raising German interest rates. As a result, there was an upward pressure on the DM as speculative money was attracted into Germany. Germany’s ERM partners were then forced to raise their interest rates to defend their currencies.

However, higher interest rates forced most of Europe into recession in 1992 - 1993. Countries such as France couldn't then get out of recession by cutting interest rates because this would have put damaging strains on the ERM. The overall result was that Europe suffered a recession because of local reunification problems in Germany.

Critics of the ERM and EMU argue that this could be repeated frequently if EMU were ever to be achieved. Local economies would suffer economic shocks because of policies, forced on them, and designed to meet the problems of other parts of Europe. One way around this would be to have large transfers of money from region to region when a local area experienced a recession, e.g. N. Ireland which suffered structural unemployment for most of the post war period, has had its economy propped up by large transfers of resources from richer areas of the UK with lower unemployment.

However, regional transfers are very small at the moment unfortunately. Moreover to approximate the regional transfers who occur at the moment in, say, Britain, there would have to be a huge transfer of expenditures from national governments to Brussels - just what anti Europeans are opposed to.

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The Change of the Stability and Growth Pact within the Euro Area

Stability and Growth Pact in March 20, 2005 states the following the complaints of the two countries, Germany and France, within the Euro area, the Ministers of Finance of the European Union agreed upon the alteration of the

The major change in the pact affects the justification of the 3 % arrears limit. The “exceptional and temporary influences” which allow higher arrears now include negative growth rates – according to the “old” version a 2 % decline in GDP was necessary. Additionally, several called “miscellaneous factors” which has been added as exceptions for a violation of the 3 % limit.

These include: expenses for research, development and innovation, development of growth potential, reforms of the retirement system, charges to support international solidarity, charges to achieve goals of the European policy and the European unification process, and others.

The general union criteria have been upheld. However, it is obvious that the variety of the exceptions will have an impact. The rules and regulations have been softened, so countries might not consider the 3 % arrears limit as their target. For example, Germany seeks to account for the expenses of the German reunification in 1990 – Germany still has a net transfer of € 85 billion or 4 % of GDP from West to East Germany per year – towards the 3 % arrears limit.

The exceptions create opportunities for various interpretations of the “miscellaneous factors”. This may lead to more violations of the union criteria, less discipline, and consequently higher risk to maintain price stability. Additionally, equal treatment of all countries seems to be problematic because of the specific characteristics of each Euro area member.

Advantage being that the Stability and Growth Pact allows for more flexible government spending, which enables countries to tackle necessary structural reforms. This may lead to increased prosperity of the European economies and sustained success of the Euro under the requirements of economic discipline.


Conclusion

The Euro developed successfully after its depreciation at the beginning of its introduction. The J.P. Morgan Index impressively supports this development, and shows the strong performance cannot just be attributed to the Dollar’s weakness.

The influence of the Euro will increase after the successful integration of the new European Union members in Eastern Europe. The prospect of the adoption of Sweden, Denmark, and the U.K. in the remote future will result in greater use and importance of the Euro. However the joining of the Eastern European countries to the EMU also bears risks for the currency.

The EMU is not a union of equals, and the inclusion of the new Eastern countries further widens the gap between the “old” and the “new” members. Therefore, uniforming of wages, prices, and economies in the EMU is crucial.

Finally, an important threat to the Euro is the possibility of decreased stability of the currency, aroused by several factors: the weakening of the Stability and Growth Pact, the government’s need to spend more money for pension and health care for its aging population, and the additional expenses for the inclusion of 10 less economically developed countries.

Conclusively, the “grand monetary experiment” has been a success so far. Looking into the future, the Euro has the chance of becoming the key currency in the world, especially in light of the current problems of the U.S.-Dollar and the increased influence and usage of the Euro. However, the challenges facing the EMU will be demanding, and synchronising economies and economic mechanisms will be crucial for the Euro to work.


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